The euro was launched at the dawn of the 21st century with great fanfare. There was hope for the new currency both as a harbinger of the future for the European experiment as also the expectation that the euro may replace the dollar as the global currency.
Now, 11 years later, the euro has been in a perpetual crisis for at least 12 months and there is no respite in sight. Originally, the euro had inherited the good reputation of the European Monetary System (EMS), which was a plan to substitute the fixed exchange arrangements of the Bretton Woods shattered by the unilateral American withdrawal in August 1971. A fixed
exchange rate system demands fiscal discipline from its members, something that the British always had difficulty managing and the Germans did with ease. The Exchange Rate Mechanism (ERM), which was the effective scheme under the EMS, allowed for a 2.5% band within which currencies could fluctuate against each other but, in effect, treating the Deutschmark as the key currency.
The next phase was launched in the Maastricht Treaty even as the ERM was going through difficulties, with the UK withdrawing in September 1992. The plan was to commit the members of the European community to a single currency along with a single market. The long-term goal was to fashion a single European economy, if not a single European Union. To do this effectively, fiscal discipline had to be formalised and the applicant members had to have a reasonably low debt-GDP ratio to show that they had repented their past fiscal sins. Germany was the model, with its Bundesbank the model for the future central bank of the single currency.
The fiscal limits were placed at 3% maximum deficit and the debt-GDP ratio was fixed at 60%. The attraction of single simple numbers was too great to worry as to whether 3% was sensible under all circumstances or should it be defined in terms of a full employment fiscal balance. The European Central Bank (ECB) was launched with an inflation mandate of 2%. Many countries managed convergence to the qualifying criteria, some like Greece and Italy, as it turned out later, by window dressing their national statistics.
The euro had good times while the credit boom of the first seven years of the 21st century lasted. Peripheral economies such as Ireland, Greece, Portugal and Spain were able to borrow at low rates and prosper. But the fiscal discipline was lost at the first whiff of a recession by Germany and France themselves. After the Lehman Brothers collapse, when credit froze, markets began to ask tough questions of the quality of debt of euro members. The ECB stayed a hawk on inflation and did not accept any old sovereign bonds. There began to be wide spreads in the bond yields of Germany and peripheral countries, sometimes as high as 800 basis points.
Fiscal crisis in the Eurozone was embedded in the notion that all the member countries could borrow from a common pool and yet the fundamental differences among them demanded a very asymmetric response. The peripheral countries should have followed a tough fiscal regime through the good times, which they did not. When the good times ended, the debt burden on the weaker countries became enormous. Bail-out schemes had to be devised but they all had to be unforgiving of past or future fiscal misbehaviour. The sovereign debt of the weaker countries had been bought by Eurozone banks, especially German banks, and they faced a meltdown of their assets.
The solution of the crisis thus proved to be politically as difficult as economically challenging. Budget cuts have been piled during a recession and for Greece there is no respite in sight for 10 to 15 years. Ireland had good fiscal numbers but incurred bad bank debt. Spain had similar problems but mainly of FDI inflows, which went into real estate and were withdrawn when the boom collapsed.
The temporary palliative has been to install a stabilisation fund that can be used for borrowing. But the fund does not allow generous time for restructuring the debt (by giving creditors haircuts) or the economy. The solution has to be politically satisfying to German taxpayers, who feel they are paying for Greek indolence.
Meanwhile, Portugal and Ireland have changed their governments.
National politics would love to break out of the euro straitjacket but EU politics do not allow that. If you need to borrow money you cannot afford national sovereignty.
The euro is a political experiment with weak economic logic. Its members are too disparate to sustain a single currency zone. Yet politics will dictate its survival, since a breakup of the euro may presage a fragmentation of the EU, and Europe is not ready to give up the political gains of the EU to get the economics right.
The author is a prominent economist and Labour peer